401K Guide

1. What is a 401k?
When it comes to retirement, long past are the days when your company sees you off with a gold watch and a fat pension. And with all the political caterwauling, banking on Social Security decades down the line probably isn't shrewd.

So how to plan for your golden years? Most corporations offer a 401k, a plan that allows you to stash cash to invest toward retirement.

Even though it has a sleep-inducing name that only a bureaucrat could love, the 401k is a potent tool to build your nest egg. And for many workers, a 401k has something especially enticing: Free Money! That's right, many corporations will match portions of your investments in a 401k. And too often folks, especially younger ones, don't take advantage of this free money.

But we're getting ahead of ourselves. First, let's get a handle on the basics. A 401k is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren't paid until the money is withdrawn from the account.

401k plans, named for the section of the tax code that governs them, arose during the 1980s as a supplement to pensions. Most employers used to offer pension funds. Pension funds were managed by the employer and they paid out a steady income over the course of the retirement. (If you have a government job or a strong union, you may might still be eligible for a pension.) But as the cost of running pensions escalated, employers started replacing them with 401ks.

With a 401k, you control how your money is invested. Most plans offer a spread of mutual funds comprised of stocks, bonds, and money market investments. The most popular option tends to be target-date funds, a combination of stocks and bonds that gradually become more conservative as you reach retirement.

While a 401k can help you save, it has plenty of restrictions and caveats. In most cases, you can't tap into your employer's contributions immediately. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401k. (Your payments, on the other hand, vest immediately.) It's an insurance against employees leaving early. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.

To oversee your account, your employer usually hires an administrator like Fidelity Investments. They'll email you updates about your plan and its performance, manage the paperwork, and assist you with requests. If you want to keep watch over your account or shift your money around, go to your administrator's web site or call their help center.

2. Should You Invest in a 401k?
In a word, yes!

With that settled, how much should you put in? As much as possible, being mindful that you'll need to have enough money to live, eat and pay down any debt you have. At the very least, invest enough to get your company match. You don't want to leave free cash on the table. Nearly every plan offers matching funds-the most popular being 3% of your salary, according to the Profit Sharing/401k Council of America.

So how would a 3% match work? If you put in 3% of your $50,000 salary, or $1,500, your company puts another $1,500 in the pot. You can add more than that $1,500 yourself, but the company won't match beyond 3%. The rules for matching funds vary, so be sure to check with your employer about qualifying for its contributions.

The IRS mandates contribution limits for 401k accounts. For 2007 and 2008, the most you can put into your fund is $15,500 in any combination of pre- and after-tax dollars. If you're older than 49, you can kick in another $5,000. The total dollar amount that can be contributed-including both your contributions and your employers'-cannot exceed 100% of your salary or $46,000 in 2008.

You'll also want to consider the type of 401k you choose. They come in two varieties, the main differences being the tax implications and the schedule for accessing your funds. Chances are your company offers a traditional 401k. Less common is a Roth 401k. Here's the breakdown of each:

Most companies allow you to enroll in a 401k right away, although some smaller employers might make you wait up to a year. If that's the case, set up an individual retirement account, and lodge a complaint with your employer's HR office. Some companies will automatically register you. You can normally increase or decrease your contributions at any time. Don't forget to elect a beneficiary, or the person who gets your money if you die. (If you're married, your spouse is automatically the beneficiary.)

Finally, if your company is on shaky ground, don't fret. You 401k is off-limits. If your company goes under, the plan would most likely be terminated. If that happens, you should roll the money over into a traditional IRA to avoid paying the 10% young-person withdrawal penalty and income taxes.

3. How Do You Make the Most of Your 401k?
Retirement might seem like eons away when your biggest concerns are student loans and car payments, but it's wise to start saving as much as you can afford now. Putting money away early in your career gives it more time to grow.

Here are some additional tips to maximize your savings:

Consider a Roth 401k
In a Roth 401k, similar to a Roth IRA, you invest money that's already been taxed. Then, when you retire and withdraw funds that money is not taxed. If you're beginning your career, you're probably in a lower tax bracket than you will be at retirement. So it might pay to suck it up and take the tax hit now, freeing you from headaches later. On the other hand, if you think your income will decline at retirement age, a regular 401k may make sense. If you can afford it, contribute to both types. That way, you're diversifying from a tax perspective and hedging your bets.

Devise an investing plan and stick to it
Create a long-term investment plan-also known as an asset allocation strategy-and choose a mix of low-cost mutual funds. And stay true to your plan even if the market falters. It'll pay off in the long run. Click on the links to learn more about asset allocation and mutual funds.

Be wary of fees for investment advice

Some employers offer investment advice to manage your account. If it's free, go for it. But be careful about paying a percentage of your portfolio to have someone guide it for you. It's usually not worth the cost for young investors with limited assets. Many companies offer free online calculators and guidelines to get you started.

Don't touch your 401k before you retire
You may be tempted to dip into your growing pool of money to splurge on a high-def TV or other major purchase. Don't. You'll pay extra fees and taxes, and you'll lose out on the glory of compound returns. Basically, by letting your 401k alone, your gains can be reinvested and earn more than you would with a smaller chunk of cash. Left alone, it can grow exponentially year after year. So try to tap into other cash sources before you raid your 401k.

Think about paying off high-interest debt with 401k loans
Wait a minute! We just told you not to tap those funds. But if you're young and deluged by high-interest credit card debt, it could be worth borrowing against your 401k to eliminate those balances. The loan comes from your own funds and you are in essence paying the interest back to yourself. Still, you should only do this if you're truly in hot water and have no where else to turn.

If you go this route, be careful. In most cases, the loan must be repaid within five years, with the interest rate at prime plus one percent. And if you lose your job or leave your company, you'll have to repay it quickly-normally within 60 days. Otherwise, the IRS sees it as a withdrawal and will get you for income taxes and young-person fees. A final caution: you can't contribute to your 401k until the loan is repaid, so you're stalling any progress you've made toward funding your retirement.

Roll over the funds if you leave your job
It may be tempting to ask your company to cut you a check, but it'll cost you a bundle in taxes and penalties. In most cases, you can leave an old 401k account alone for as long as you want, where it will remain with the brokerage firm that administers your account. If your former company kicks you out of the plan, you'll need a new home for your funds. The best options are to roll the funds into an IRA, or into a 401k at your new job. Make sure you talk with your plan administrators-as well as the new firm where you'll park your money-to be certain you follow the rollover rules and avoid penalties.

4. Grilling Guide: Questions to Ask Potential Employers about 401k Plans
In most cases, you won't choose an employer based on its 401k plan. But it can't hurt to learn about retirement benefits before you take the job. Here's what you should find out about your future company's plan:

What's the minimum I must contribute to get the employer's entire matching contribution?
Plans vary, but often you have to contribute extra to receive your firm's entire match. Some employers contribute 50 cents for every dollar you put in, meaning you'd need to add 6% of your paycheck to hit the full 3% match from your company.

What are the rules for employer contributions to become vested?
The longest a company can make you wait is three years to full vestment, or a gradual vestment over six years.

Do you have profit-sharing plans or money-purchase plans?
If so, take advantage of it. Essentially, your employer deposits money into your 401k, and you don't have to contribute anything to get it. Now that's free money.

Does the 401k charge me any fees?
It can be hard to determine how much you're paying beyond the cost of the mutual funds you invest in, but there is administrative overhead in running a plan. The Labor Department is encouraging firms to improve fee disclosure, so make sure you get all the fine print from your employer.

Are there restrictions on 401k loans?
Most plans allow loans, though employers can restrict your borrowing to major expenditures like home purchases, medical expenses, or education costs. Usually, you can borrow half of your vested account balance up to $50,000.